Foreign Portfolio Investment and Sustainable Development A Study of the Forest Products Sector in Emerging Markets October 1998 Maryanne Grieg-Gran, Tessa Westbrook, Mark Mansley, Steve Bass and Nick Robins International Institute for Environment and Development 1. Introduction 1.1 Background At the Rio Earth Summit in 1992 it was recognised that substantial financial transfers from the North to the South would be necessary for sustainable development to be achieved. It was assumed that much of these resources would be provided from public funds such as official development assistance. Somewhat less attention was given to the role of the private sector in these transfers, although Agenda 21 did stress the need for policies to increase the level of foreign direct investment (UNDPCSD 1997). However, in the last ten years there has been a marked increase in private capital flows to developing countries. Since 1986, these flows have grown from some US$25 billion per annum to over US$240 billion. At the same time official (public) flows have been declining in real terms such that by 1995 they accounted for less than 15% of aggregate net resource flows to developing countries compared with nearly 70% ten years earlier (World Bank 1997). The increase in private capital flows has generated an intense debate about their impacts on developing countries. Proponents emphasise the positive impacts of such flows on growth and industrial development while critics express concern about the growing power of large transnational corporations, repatriation of profits and increasing indebtedness on the part of developing countries. More recently, the environmental and social impacts of private capital flows have received increasing attention. A common concern is that the economic growth resulting from such flows is unsustainable where it involves environmental degradation or adversely affects vulnerable groups of society. However, the potential contribution that private capital flows could make to sustainable development is being increasingly recognised. For example, in a recent review Gentry and Esty (1997) emphasise that the target of Governments should be “to harness the power of private investment to the achievement of a sustainable future”. 1.2 Objectives and Scope of this Paper The objective of this paper is to examine the issues involved in harnessing a particular type of private capital flow, namely portfolio equity, to achieve sustainable development objectives. While portfolio equity is not the most significant source of private capital, being exceeded by foreign direct investment, it has been growing the most rapidly, increasing more than fifty fold from 1986 to 1996 (although the current difficulties in Asian markets will no doubt have affected this rate of growth). In addition, the growth of ethical and green investment funds suggest increasing interest in the environmental and social impact of portfolio investment. For these reasons we focus on the potential of portfolio investment as a lever for sustainable practice and on portfolio equity in particular. The aim is to consider whether and how such flows can be used as a form of leverage to encourage activities that are considered to be sustainable and to discourage those with adverse environmental and social impacts. This requires consideration of two questions: • First, what type of impact does portfolio investment have on the development process? To what extent is it possible to link portfolio investment to positive impacts such as economic growth or to adverse impacts such as volatility, environmental degradation and social inequality? 1 • Second, what is the justification for governments and other stakeholders to intervene to influence portfolio equity flows to the South? Can sustainable development objectives be delivered by financial markets in their existing form, given the existence of green and ethical funds, or are there sources of market failure which need to be addressed? We first review the debates in the literature on these two questions. However, in order to ground the arguments in the constraints and complexities of a particular sector we complement this review with a case study of the forest products industry, focusing in particular on tropical timber companies registered in Malaysia. There are a number of reasons for choosing the forest products sector: First, the forest sector in developing countries has been a major focus of concern within NGOs and many international agencies such as the World Bank over the last two decades. Some of the most rapidly growing emerging economies, for example Malaysia , Indonesia and Thailand, have significant forest product sectors and have been the target of both local and international NGO campaigns to improve forest management and prevent deforestation. Second, there have been some highly publicised attempts to influence investment in the sector. For example, in 1993, a consortium of NGOs organised a campaign to dissuade investors from purchasing shares issued by Barito Pacific, a major Indonesian forest products company. While not successful in affecting the take up of shares, the campaign raised awareness of the wider impacts of foreign portfolio investment. Thirdly, there have also been significant developments in the area of certification of forests. A number of initiatives have been established, both international such as the Forest Stewardship Council and national such as the Canadian Standards Association’s scheme. By July 1998 over 10 million hectares of forest had been certified (FSC 1998). While the aim of the certification initiative is primarily to influence consumers’ decisions it can also provide useful information for investors. In the case study we attempt to track portfolio equity flows to the forest products sector in Malaysia. This country was selected because it has a significant forest products sector and an established financial sector, and because a number of environmental organisations have expressed concern about the forest management practices of Malaysian timber companies, particularly with regard to their offshore operations. We attempt to assess whether foreign portfolio equity is being channeled to companies considered to have poor environmental and social performance. The aim is to establish whether in the context of a particular sector there is any scope for leverage. 1.3 Approach As this paper is intended to be an exploration of the issues related to portfolio investment and sustainable development, we rely heavily on existing literature. However, in order to estimate the extent of foreign portfolio investment in the forest products sector in Malaysia we have collected data on investment holdings from a variety of sources including company reports, brokers’ sector reviews, fund managers’ reports, Bloomberg and Extel, and the Kuala Lumpur Stock Exchange. In order to gauge the attitudes of the investment community towards the environmental and social impacts of portfolio investment we have interviewed ten fund managers or research analysts from funds which have invested in the forest products sector. These interviews were intended to highlight issues for subsequent research rather 2 than to be statistically representative. Such a survey would have been outside the scope of this present research. The discussion of the environmental and social performance of forest companies was derived from existing literature, including broker’s reports and NGO reviews. 1.4 Structure This paper is structured as follows: • Section 2 surveys recent trends in portfolio investment flows to developing countries and examines the factors contributing to their spectacular growth. • Section 3 surveys the literature on the relationship between portfolio investment and sustainable development. After a discussion of the perceived benefits of these flows in terms of economic growth and industrial diversification, the chapter considers some of the concerns expressed in the literature about the adverse economic, social and environmental impact of portfolio investment in general. The arguments for attempting to influence portfolio investment are then discussed. The different types of market failure associated with portfolio investment are reviewed as well as the policy options which are most appropriate for addressing these failures • Section 4 examines the first of the two research questions specifically in the context of forestry. Particular emphasis is given to the forest products sector in Malaysia. It first attempts to assess the magnitude of portfolio investment to the forest sector, describing trends in such flows, the performance of forest equities relative to those of other sectors and the future prospects for such investments. It then considers whether such investments can be linked in any way to poor environmental and social performance in the sector. • Section 5 looks at the second research question in the context of forestry. It considers how applicable the arguments for attempting to influence portfolio investment flows are to the forest products sector and explores some policy options. • Section 6 provides a summary of conclusions and recommendations and identifies research needs to explore investment issues in more depth in the forest products sector and other sectors. 3 2. Portfolio Investment Flows To Developing Countries 2.1 Trends in capital flows to developing countries Over the last decade both the size and composition of capital flows to developing countries has changed markedly (see Box 2a for definitions